What is a business emergency fund?

So, you have a personal emergency fund already? 

Excellent. 

But you might also have a side hustle, small business or have other interests that are dependent on cash flow. For example, my wife is self employed and has just hired her first employee. The landscape changed very quickly – as the business grows, she needs to adjust her money goals and cash flow to make sure she can pay salaries at the end of the month. 

We also know from happenings over the last few years that things happen – whether lockdowns, interest rate hikes, large clients leaving or legislation forcing large corporates to extend their policy on payment terms.

I know the term emergency fund isn’t the norm for businesses, but, whatever you want to call it – you need some cash in case something detrimental happens to your business. 

Your business and its emergencies

With a normal, personal emergency fund, we can estimate quickly that emergency fund of at least a 3 months’ expenses is needed .

But with small businesses and freelance work, it’s a bit different. Some businesses sell products, whereas others offer a service. If you’re offering a service such as software development or interior design, it tends to be the time that you are sacrificing for money.

On the other hand, if you are offering a product, you might need to buy ingredients, hardware, physical merchandise or similar. I recently heard of a corporate asking for a 90-day payment term – this means you will need to supply them with your products for 3 months before you get your first payment! In this case, you might need more than 3 months when starting the business relationship!

Strategic foresight for your business

Things happen, yet we tend to be ignorant about them. What would happen to your business if:

  • you need bridging capital between buying and selling?
  • your corporate client pays 120 days later?
  • the costs on a project spiral out of control and you need to cover the costs?
  • your biggest client decides to leave today.

This can easily cause a business to fail. For the sake of survival, we need to make sure we know what could go wrong – and plan accordingly.  Strategic foresight means you have thought through your business needs, you develop contingency plans which will be able to cover these changes. Having money available in an emergency is part of this.

Cash flow and small business

One of the biggest killers of any business is cash flow. If you’re self-employed or have a sideline business that needs cash to keep going, you might need a business emergency fund.  

I normally tell people that cash flow is like blood in your veins – it brings life to your body whereever it flows. Now, imagine having severe cholesterol. This stops the life giving flow to get to the places where it needs to go. This is how cash flow works – if you’re out of cash, you will not be able to grow accordingly.

Death by growth - managing emergencies and cash flow

So, I have this friend. He owns a company that resells shoes. It started out with 3 pairs but has grown exponentially in the last few months. The issue that they’re having now is they need more stock than they have money in the bank. 

The choice between growth and cash flow is a difficult one, with no one-size-fits all approach. In this case, some companies get funding, whereas others stay small and optimise the process.

Whichever route you choose, make sure your lack of cash flow will not kill your company – and having that extra buffer will make all the difference.  

How much do I need to save?

Personally, I believe that a company should have at least 3 months’ operating expenses in case of an emergency. I know there are many types of insurances that can be bought to lower the risk – and these are good, but nothing beats cold hard cash when you’re in crisis.

It is worth mentioning that for some people, emergencies aren’t only car crashes and server breakdowns. It might also be when clients dry up, unplanned legal expenses due to client issues and so forth. Don’t think it’s just for death and disability! Here are some more points to determine how much you need:

  • Receivables and inventory: if you have lots of products/stock and your payment terms are longer than 30 days, then you might need money to cover the shortfall during this period.
  • seasonality: Some businesses are only active in summer or holidays such as ice cream shops and holiday homes. Your emergency fund will need to carry you through off season times! 
  • Business structure: Each company structure is affected differently, but all the same. Whether you’re trading as a sole proprietor, a company and/or have employees – make sure you’re prepared!

Making a list of running expenses and once off expenses can give you an idea of how much you need if your cash flow dries up. Other than yourself, what are your monthly expenses? For example, do you have staff, renting office space, have third party bills that need to be paid (suppliers, IT support, servers, etc.)?   

If you’re self-employed, consider the size and intervals of your projects. For example, if you sell something small to lots of clients, the risk tends to be slightly lower, whereas if you have one big project every two years, with a build-up of 1 year of preparation, you need money to carry you through the tough times – even if the cash is there right now. 

Cons of having an emergency fund

No one would’ve thought it a bad idea to have a business emergency fund – right? But there are some cons. Here are some of the biggest issues:

  • Investment limits – you cannot invest the money in your business emergency fund 
  • You won’t have a large return on your emergency fund, as the money needs to be available within 48 hours.

Conclusion

If you’re running a business (side hustle, freelance or other), you might want to have an emergency fund available to you. Recent events over the last 2 years have shown that we need to have money available if cash flow dries up due to unforeseen circumstances. 

We have seen insurance companies declining payouts and delaying payments – such as the case here

I know that many will argue that leveraging debt in a business is a sure way of optimising returns – and that might be true. For small businesses such as coffee shops, freelancers, dog parlours, software developers and interior architecture firms, having cash flow and good money management could be the difference between life and death.

Happy investing!

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Money Local

Frugal Local runs his own company (Effectify). He does software development and helps small businesses and startups with digital solutions. He enjoys writing articles and simplifying complex things - such as the article you're reading!